Q2 Economic Growth Surprises; Small-Caps Play Catch-Up; But Incoming Data Imply Underlying Economic Softness

On Thursday (July 25^th), the initial Q2 GDP estimate, at 2.8% (annual rate) was, to say the least, quite a surprise. The consensus view was +2.0%, and the +2.8% growth rate doubled Q1’s 1.4%. The equity markets’ initial response, however, was a tepid one for most of the day. And, by the end of the day, markets succumbed to selling pressure (Nasdaq: -0.9%, S&P500: -0.5%). Of the 2.8%, unwanted inventory accumulation accounted for +0.8 percentage points, and government spending growth added another +0.5 percentage points. Another positive for GDP was a drawdown in the savings rate (to 3.5% in Q2 from Q1’s 3.8% and over 5.0% a year ago), no doubt aided by the wealth effect from a rising equity market, at least for higher income consumers, and by record high credit card balances. In real terms, consumer spending rose at a 2.3% annual rate while after-tax personal income only rose at a 1.0% rate (thus, the record high credit card balances – but, we note, with high and rising delinquencies). Such a gap between spending and income cannot persist for very long. According to Rosenberg Research, without the spending growth in the government sector (which will be severely constrained in the future by rising debt costs as the average interest rate on outstanding debt increases), the unwanted inventory accumulation, and the savings rate drawdown, Q2’s real GDP growth would have been closer to +0.5%.

That was Thursday. On Friday the headline Personal Consumption Expenditure Index (PCE), the inflation gauge most closely watched by the Fed, came in at +0.08% (rounded to +0.1%) for June (vs. May). That lowered the year-over-year inflation rate to 2.5% from May’s 2.6% reading. The Core PCE Index rate (ex-food and energy) was +0.18% (rounded to +0.2%) for June and 2.6% on a yearly basis (May’s year-over-year rate was also 2.6%). This relatively subdued reading moved the equity markets higher (DJIA: + 1.64%, Nasdaq: +1.03%, S&P500: +1.11%, and Russell 2000: +1.70%). But, as the table shows, those gains were not enough to move the S&P 500 or the Nasdaq out of negative territory for the week.

With a large rise on Friday (654 points), the DJIA did end the week slightly positive while the small cap Russell 2000 posted nearly a 3.5% weekly gain. That small cap index has nearly caught up to the S&P 500 and the Nasdaq on a year-to-date basis, and has now performed better than the DJIA. Just two weeks ago, it was flat year to date. Clearly, sentiment has now shifted away from the large cap (tech) companies. The next table shows the performance of the Magnificent 7 over the week and from their recent peak prices to their closing values on Friday (July 26^th). Note that they are all down from their peak prices set earlier in the month. And note that the price of each of them fell last week despite the market rally on Friday.

The recent move in the small cap Russell 2000 deserves some discussion. About 40% of the companies in that index are unprofitable. Leverage (i.e., debt) is often an issue with these small cap companies. The markets’ expectation of Fed rate reductions has undoubtedly played a key role. After Friday’s PCE Index release, markets now place very high odds on the probability of Fed rate cuts at their September, November, and December meetings. While the Magnificent 7 and the large cap stocks have already seen their stock prices rise substantially (with their PE ratios in the 95^th percentile), until recently, the small cap stocks haven’t participated. The projected Fed rate cuts should ease the leverage burden on those smaller companies; one explanation for the recent rally there.

Incoming Data

Equity markets clearly believe in a “soft-landing” or a “no-landing” scenario for the economy. But most of the incoming data aren’t cooperating.

• The Chicago Fed’s National Activity Index showed up negative again in June and hasn’t shown a positive reading since 2022. This is an 85 variable model that has an excellent track record when it comes to monitoring economic growth.

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• The Philadelphia Fed’s Non-Manufacturing Index also was negative in July (-19.1), quite a fall from June’s +2.9 reading. Of note, full-time employment contracted as did the workweek.
• The Conference Board’s latest Leading Economic Indicators were also negative in June and are down nearly -15% from their peak. This has always been a reliable indicator of the economy. And we have never had a period of negative readings this long in the post-WWII period without a Recession.

• Existing Home Sales fell -5.4% in June from May levels. Such sales are now down that same -5.4% on a year over year basis.

• Unsold Existing Home Inventory, at 1.3 million units, is now at the highest level since May 2020, and is up more than +23% from June ’23 levels. In addition, New Home Sales fell -0.6% in June and are off -7.4% from a year earlier. The tepid pace in the housing industry also shows up in the cancellation rate of homes under contract. In June, according to Redfin, 56,000 homes, equal to 15% of homes under contract, cancelled. That cancellation rate is a record high for June. In additionm there were price cuts on 20% of listings in June (vs. 14% in June ’23).

Inflation

Supply chains have healed, Uncle Sam’s Covid cash giveaways have been spent (and then some as seen from the falling savings rate), and consumption has risen faster than incomes. Economic softness will be the result.

In the world of commodities, the raw material inputs in the manufacturing process, prices are tanking (see right-hand side of the chart).

Rosenberg Research recently noted the following price declines from nearby peaks:

• Copper: -16%
• Aluminum: -17%
• Lead: -11%
• Nickel: -25%
• Zinc: -14%
• Ag & Livestock Index: -10%
• Energy: -10%
• Textiles: -6%

It also appears that the economy is now at the point where CPI inflation will be dragged down by rents, making it easier for the Fed to justify rate cuts. While shelter has a 36% weighting in the CPI, rents and other shelter components in that index are lagged by nearly a year.

The chart shows that since mid-2023, rents have been falling (down -0.7% in June from year earlier levels). Since shelter has such a heavy weighting, and since rents have been falling (under the zero line) for more than a year, the lags in the CPI methodology will finally show negatives for the shelter component. That, along with falling prices of goods, indicates that inflation will to continue to fall. In fact, as expressed in prior blogs, we see possible deflation in 2025.

Corporate Performance

Here is a sampling of Q2 reports by some important companies showing economic softness:

• UPS missed on Q2 earnings and sales noting a slower consumer. This was the second quarterly miss in a row;
• FedEx will lay off 500 pilots and will cut domestic flight activity (the result of losing the U.S. Postal Service Contract to UPS);
• Nestle cut its full year guidance indicating that consumers are seeking cheaper alternatives;
• Southwest Airlines’ profits fell -46% in Q2;
• American Airlines slashed its earnings outlook;
• Tesla says EV demand is drying up;
• Comcast’s revenues (mainly theme park and movies) fell in Q2;
• AT&T reported that net income fell -20% in Q2 and revenues were off (-0.4%).

The Fed

It is clear from the housing numbers and some soft corporate numbers that restrictive Fed policy is having a dramatic impact. In the existing home market, most households locked in low mortgage rates in the pre-2022 low-rate era. As a result, there is a reluctance to move as new mortgage rates are high (6.77% per the Federal Home Loan Mortgage Corporation (FHLMC)). It is also clear from the data that monetary policy restraint in no longer needed. Yet, even if the Fed lowers rates three times before year’s end (in September, November and December), that would only take the Fed Funds rate to the 4.50%-4.75% range. The Fed says neutral (neither accommodative nor restrictive) is 2.75%. So, even three rate cuts by year’s end still leaves monetary policy deeply in restrictive territory. To get to neutral, the Fed will have to do an additional seven 25-basis point rate cuts. Given the speed and deliberation with which the Fed acts, that will likely take all of 2025, if not longer, to accomplish. Let’s also remember that monetary policy acts with long and variable lags. So current actions take several quarters to have an impact. As discussed in past blogs, it appears clear that this Fed is way behind the curve.

Commercial Real Estate (CRE)

We have been commenting on the softness in the CRE market for several months. The situation continues to deteriorate. In the first picture below, the building on the left-hand side is located on Union Square in San Francisco. It has a $47 million debt and only a 65% occupancy. Foreclosure is proceeding. The building on the right-hand side is in downtown Los Angeles. It has $290 million of debt on it and is being purchased for $120 million, $170 million less than the debt owed. Some institution is taking a large hit!

In the next set of pictures, the building on the left-hand side is a vacant laboratory in Seattle with $117 million of loans outstanding. The lender, as the new landlord, intends to invest more capital and to lease up the building (as if the former owner didn’t try to do that!). On the right-hand side of the picture is a Silicon Valley office complex originally purchased for $358 million in 2021. This office complex is going back to the lender who has a $200 million loan on it.

There were several more large foreclosures last week. Thus, it is clear that the CRE market continues to deteriorate. Concern should be rising about the quality of loan portfolios among U.S. lenders, especially small and medium sized banks who often have a relatively large percentage of their loan portfolios secured by CRE.

Final Thoughts

While Q2’s GDP came in higher than expected, there were several noteworthy reasons including: 1) unwanted inventory accumulation; 2) high but unsustainable levels of government spending; 3) a continued drawdown in the savings rate; and 4) record high credit card balances with rising delinquencies. If those four factors had been “normal,” GDP growth would have been 0.5%, not 2.8%. None of these factors are sustainable. In addition, leading indicators and Regional Federal Reserve Bank surveys all point in the same direction, i.e., economic softness appears to be on the horizon.

There appears to have been a shift in investor sentiment, away from the large cap tech and the Magnificent 7 and towards small cap stocks. Over the past couple of weeks, the Russell 2000 (small cap) has gone from being flat year to date to now rising in the double digits. The prospect of lower rates which helps highly levered small businesses, is likely a major reason. Note, also, that none of the prices of the Magnificent 7 rose this past week. Has the torch been passed? (It has for the Olympics!)

Both New and Existing Home Sales fell in June. High mortgage rates were, undoubtedly, the prime reason. Because monetary policy acts with long lags, even if the Fed makes three rate cuts this year, monetary policy will still be uber-restrictive. Under such circumstances, housing will continue to struggle.

The CRE market continues to deteriorate. Last week, there were reports of large foreclosures every day. Small and Medium sized banks are major players in the CRE space. We suspect banking issue will soon emerge.

But let’s end this blog on a high note: Inflation appears to be on the wane. Having spent at a much faster pace than slowly rising incomes would normally permit (and now with rising credit card delinquencies), consumers are starting to cut back as seen from lower guidance and comments about consumers seeking lower prices from major corporations during their Q2 reporting. In addition, just from the construction methodology of the CPI, the lags in the shelter component will be putting significant downward pressure on inflation for at least the remainder of 2024.

(Joshua Barone and Eugene Hoover contributed to this blog.)